About Private Mortgage Insurance

Private mortgage insurance, commonly known as PMI, is usually required by lenders if a borrower purchase a property with less than 20% down. It allows people to purchase homes with a lower down payment and protects lenders who choose to make these riskier loans. It does make home ownership more expensive for borrowers for the first several years until the borrower's equity is high enough to cancel the insurance, but borrowers may find the tradeoff worth because PMI allows them to buy a home sooner.

Function

This insurance policy protects the lender if the borrower stops making mortgage payments. However, it is the borrower that must pay PMI. Some people think it is unjust that the borrower has to pay for a policy that protects someone else. However, paying PMI allows banks to be more secure in making loans with a higher loan-to-value ratio, which allows many people with small down payments to purchase homes long before they could if a 20% down payment were required. In that sense, PMI benefits the borrower, too.

Time Frame

The borrower is not required to pay private mortgage insurance forever. Once the borrower has accumulated significant equity in the home (usually between 20% and 25%), the lender will consider its risk to be mitigated to the point where the borrower will be allowed to cancel PMI. This equity can be accumulated by an increase in property value, by paying down the principal on the mortgage, or a combination of the two. There is also usually a requirement that a certain amount of time has passed since the loan was taken out (such as two years). The requirements for canceling PMI will vary by lender.

Effects

While PMI does enable many people that otherwise would not be able to purchase homes, it also makes home ownership more expensive. On an FHA mortgage, for example, PMI costs about .055% of the loan amount per year at the time of this writing. On a $240,000 home with 3% down, PMI would cost about $1,280 per year, or about $107 per month. Many lenders also require an up-front PMI payment. Using an FHA mortgage as an example again, the up-front mortgage insurance cost would be 1.5% of the loan amount. On the same home, that cost adds $3,492 to the purchase price of the home and thus to the loan balance. This further increases the borrower's monthly payment unless he or she pays the up-front mortgage insurance in cash. People do not often choose this option, however, because of the other large cash expenses required to move into a new home, such as the down payment and closing costs.

Considerations

Increasing the down payment will reduce the borrower's monthly PMI payment, but since PMI is such a small percentage of the loan balance, the monthly PMI payment will barely decrease. There are better potential uses for that extra down payment money, such as paying points to reduce the interest rate, making improvements that will increase the home's value, or keeping the money in an emergency savings fund. The only case where it would probably make financial sense to increase the down payment to reduce PMI is if the increased down payment would eliminate the need for PMI altogether.

Warning

Sometimes borrowers have difficulty getting lenders to cancel PMI even once they have reached the required LTV ratio. After all, from the lender's perspective, it is getting free financial protection. It has no incentive to make it easy for the borrower to cancel the policy. However, legislation called the Homeowners Protection Act should start helping eligible borrowers get PMI canceled easily, if not automatically, beginning in 2009.